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Investing in Green Innovation

As companies plan their green investment strategies for 2008 and beyond, they should take into account that caps on carbon emissions are all but inevitable in the future. In fact, it is highly likely that caps will be in place in the US within the next few years. The 187 nations that attended the UN climate conference last month in Bali (including the US) agreed to negotiate a successor agreement to Kyoto by the end of 2009. Perhaps more importantly, Congress already has several climate bills under consideration.

How aggressive will carbon reduction targets be? A recent Human Development Report by the United Nations Development Programme concluded that developed nations needed to reduce carbon emissions by greater than 80% from 1990 levels by mid-century in order to advert the worst impact of climate change. Under any implementation scenario, carbon caps will likely be imposed over many years, if not decades, providing a window of opportunity for companies to adapt to and compete in this new world order.

In many ways, the imposition of carbon caps will reset the current competitive landscape. Those businesses able or willing to adapt more quickly to this changing landscape will likely secure a competitive advantage by differentiating their brand or products, or by improving their cost basis.

Despite the arguments for moving quickly, many companies will likely delay investment in green as long as they can, and do so for seemingly good reasons. First, exact targets are uncertain. Second, the timeline for implementation may take years, if not decades.

Finally, the misuse of financial practices may preclude smart green investment. A recent Harvard Business Review article, Christensen et. al., suggests that there are three ways that incorrect financial practices suppress investment in innovation. Marketing Green believes that as green investments are largely investments in innovation, it is very likely that the misapplication of financial practices that impede innovation may also hinder prudent investments in green. (Clayton Christensen, Stephen Kaufman and Willy Shih, “Innovation Killers: How Financial Tools Destroy Your Capacity to Do New Things”, Leadership & Strategy for the Twenty-First Century, Harvard Business Review, January 2008). Here is how:

Cash flow modeling: Companies often do not fairly compare the projected discounted cash flow from a new investment with that generated from current operations because they assume that current cash flow will remain constant in perpetuity.

In fact, as Christensen et. al., explain, this may not be the case: in the absence of continuous “innovation investment”, the more likely outcome is a “decline in performance” in existing operations. Without this downward adjustment, however, financial analysis creates a “systematic bias” against innovation in new products or processes – green or otherwise.

Asset Lifetime: Financial managers may mistakenly assume that that an asset’s usable lifetime should be based simply by its depreciation period, rather than its “competitive lifetime”. Said differently, even though the continued use of an existing asset generates a more attractive return in the near-term (typically because capital equipment costs are already sunk and therefore not included in the calculation) than an investment in a new asset, it may not be the best decision for a company if it wants to maintain its competitiveness (and cash flow) longer-term.

A famous example cited by Christensen et. al., is the case of Nucor and US Steel. Nucor invested in new minimills that yielded a low average cost of production. Instead of following suit, US Steel stuck with its existing mills because the marginal cost of producing incremental steel was lower than investing in minimills (because it was simply putting excess capacity to use) and therefore more financially attractive in the short term.

In this case, US Steel incorrectly relied on marginal cost analysis to inform its decision regarding whether or not to invest in new plant technology. As Christensen et. al., point out, “When creating new capabilities is the issue, the relevent marginal costs is actually the full cost of creating the new.” As a result, US Steel’s average production cost remained much higher than Nucor’s and Nucor was able to out compete US Steel longer term.

Applied to the green space, many companies may decide to defer investment in greener technologies given the upfront capital requirement to do so. This decision may extend the life of less efficient technologies, manufacturing processes or products in the market. Yet, it may prove disadvantageous longer term as other competitors or new entrants make more aggressive investments that generate a more sustainable competitive advantage when carbon caps become more restrictive longer term.

Quarterly earnings: Companies that focus on quarterly earnings may systematically under invest in innovation as they are not rewarded by the market for doing so. Given that the time horizon for green may take years to pay off, green initiatives may likely be underfunded relative to initiatives that are able to contribute sooner to earnings.

Marketers need to think strategically about their investment in green. Caps on carbon emissions will reset the competitive playing field, though they may be imposed gradually over years, if not decades. Early movers may enjoy a competitive advantage in the market based on their brand, products or cost position.

There is a good chance companies will underinvest in green due to regulatory uncertainty and the misuse of financial practices that may favor investments that yield near-term benefits at the expense of long term competitiveness.

Marketers must understand and compensate for bias that leads to underinvestment in green. Formulate a strategic vision for green, properly balance the risks and rewards and invest for the long haul. Your shareholders will thank you.